Baby Step 6: Paying Off Your Home Early

When we talk about mortgages Dave talks about how he thinks you should have no more than a 15 year fixed rate mortgage, and that your payments should be no larger than 25% of your monthly income. For many people that doesn't seem doable because of the housing markets they live in, or because of the standards they've set for the home they want to live in. Sometimes people just aim too high! In any event, in most cases it is something that most people can do – take on a 15 year loan for less than 25% of their income.

I will be the first to admit that we've taken on a 30 year mortgage at our house because when we bought the house we weren't as serious about our finances, and we were over the 25% of our income as well. At the same time we have no other debts to speak of, and since we bought the home our income has gone up – to the point where it is no longer over that 25% number. In any event, we're also paying extra on the mortgage now to help pay it off early.

So what do you get by paying off the mortgage early? You'll be giving yourself peace of mind in a tough economic climate knowing that your house is paid off. If the worst happens and you lose a job or have a medical emergency, you’ll be able to get by on a whole lot less. After all, the house is paid for!

Why You Should Pay Off The House Early

If you read personal finance blogs, there are a lot of arguments in favor and against paying off your home early. Which is the better for people financially? To pay off their mortgage early, or to save and invest the money for the long term?

First, here are some points in favor of paying off the mortgage early:

Save Money On Interest: If you pay off your mortgage off early, you'll be saving thousands of dollars in interest. Think about this: If you have a $200,000 dollar mortgage for 30 years, with an interest rate of 6%, at the end you'll have paid $250,000 in interest. Change that to a 15 year mortgage and only $115,000 in interest will be paid. If you can pay down the mortgage even faster than 15 years, you'll be saving even more because you'll be paying less interest.

Mitigate Your Risk: One of the most attractive things about paying off the mortgage early to me is the fact that it helps to minimize the amount of risk that you have in your life. With a paid off house you don't have to worry about mortgage payments. If you can scrape enough together to pay for food, transportation, clothing and utilities, you should be able to get by. Without a mortgage that number is significantly lower. Trying to invest the money and come out ahead may work for some, but because investing is inherently risky (we've seen that in the last year or two), it could mean adding risk to your life as well.

Financial And Emotional Peace + Less Stress: With no mortgage I know that we would be much closer to true financial and emotional peace just because we wouldn't have the debt weighing on our shoulders – and the risk of losing our home to a job loss or medical issue are greatly reduced. So less debts and obligations mean less stress in our household. Add to that the fact that you’ll have less stress when having to deal with a job change, or wanting to become a one income family so one spouse can stay home with the children. When you have a paid for house you’ll only need to cover the minimum of life's essentials – and you'll have walkaway power – power to walk away from any job you don’t love or enjoy because you only have minimal expenses!

With A Paid Off Mortgage You Get A Huge Raise!: When your monthly debt obligation drops so significantly because you've paid off your house, it means that your income will go up significantly. Can you imagine how much money you could save, invest and give if you didn't have a mortgage?

Being debt free brings freedom, and sometimes that’s better than a few extra dollars made through investments.

Arguments For Investing Instead Of Paying Extra On House

There are some pretty good arguments that others have made against making extra payments on a house. Here are the few that made the most sense to me:

Keeping Your Holdings Liquid = Flexibility: When you have your money in investments as opposed to prepaying on a house, the money is going to be more accessible if you absolutely need to access it. When your money is being invested in a house, you can't exactly just cash it out – you still need a place to live. So many would suggest that investing your money will give you more flexibility in the case you need to access your money in an emergency.

Returns On Investing Will Be Higher: If the money you expect to make in the stock market is more than the amount you'll save by pre-paying your mortgage, than it may be a better bet to invest your money.

Inflation Is Your Friend?: Inflation goes up by a rate of 3-4% every year, so by not prepaying your mortgage you are in essence paying less money for a house that is increasing in value every year. The amount you pay in 2040 to live in your house is the same as you're paying in 2010. You'll be getting more for your money!

No Asset Diversification: By only investing in your house, some argue that you're not properly diversifying your holdings – you're only investing in one asset type and class. Better to invest and diversify your holdings.

The arguments for investing vs. paying off your mortgage early really do make a good case, although I will admit some of them hold less merit for me than others.

What We're Doing

We've considered both sides of the argument at our house, and in the end the thought of having a paid off house – and no mortgage debt – just appealed to us more. We love the idea of having the freedom and the walkaway power that goes along with having a paid off mortgage.

At the same time, we still want to invest. So what we're doing at our house is a little of both. We're both investing for our future, and we're pre-paying our mortgage to the tune of several payments per year. We may not pay off the house as fast this way, but we'll still be paying it off years early.

What do you think about paying off the house early? Do you think it’s a good idea or a bad idea? Which path are you choosing if you’re at that point? Tell us in the comments!

The number of refinance requests has exploded in recent weeks, but if you’re undecided about refinancing, here are five reasons why acting now might make sound financial sense.

1. Slash Your Monthly Payments. It doesn’t take a math-centric mind to calculate that lower interest rates equal higher savings. As long as closing costs are kept down, even a quarter-percentage point reduction can be worthwhile.

If you’re paying substantially higher interest rates than today’s average, you stand to save tens of thousands of dollars by refinancing today.

2. Save by Shortening the Term of Your Loan. Although rates for 30-year fixed mortgages now average close to 3.5 percent, rates for 15-year mortgages are even lower – less than three percent in some cases.

Historically, homeowners who trade 30-year for 15-year mortgages obtain lower interest rates in exchange for higher monthly payments. Given today’s low rates, though, you may find that the monthly payments on a 15-year mortgage aren’t much higher than those on a 30-year loan.

A shorter term helps you pay off the mortgage faster. Depending on your loan amount, you could save more than $100,000 in total interest by reducing the APR by one or two percentage points.

Switching to a shorter term makes the most sense for borrowers with secure jobs or enough savings to ensure that they can meet the payments if they suffer a temporary loss of income.

3. Switch from an Adjustable Rate to a Fixed Rate. If you have an Adjustable Rate Mortgage (ARM), now is a good time to lock in a lower rate rather than risking higher rates in the future.

This is especially true if you opened an ARM loan a few years ago. The low introductory rates offered by ARMs back then are often higher than today’s fixed rates.

If your low introductory rate has expired, that’s even more reason to refinance to a fixed rate.

Most mortgage lenders and brokers recommend fixed rates. Why? An ARM’s introductory rate is typically not significantly lower than those of fixed-rate mortgages. In today’s interest rate environment, ARM savings usually do not justify the risk of skyrocketing rates in the future.

4. Get Rid of Your Mortgage Insurance. If you have at least 20 percent equity in your home, you can get rid of the extra monthly expense of mortgage insurance.

If you’re not sure how much equity you have, consult a real estate agent or a mortgage professional for an estimate of the home’s current value. If – like many properties across the country – the value has risen in recent years, your equity has also increased.

Then, request a professional appraisal. That is the official document that proves your home’s new value. With it, you can qualify for a new mortgage with a lower rate and no mortgage insurance payments.

5. Eliminate Closing Costs for the New Mortgage. One reason given by some homeowners for not refinancing is that the closing costs of a new mortgage could negate the other financial benefits.

If you opt for a zero-closing cost mortgage, however, you save money monthly and pay nothing for the privilege.

Zero-closing cost mortgages are exactly what the name states – loans with no closing costs.

Most lenders require a slightly higher interest rate in exchange for eliminating the closing costs. But for loans of $250,000 or more, the rate increase is so slight – usually 25 basis points (0.25%) – that borrowers still reap substantial benefits.

And for loans exceeding $400,000, the rate typically inches up by only 12.5 basis points (0.125%).

With rates so low, many homeowners are refinancing with no costs, and still dropping their current rate significantly.

No-closing cost mortgages are available across all loan types, including FHA loans, VA loans and conforming mortgages (those conforming to Fannie Mae and Freddie Mac guidelines). Zero-closing cost mortgages are available in all 50 states.

Next Steps for Homeowners

Today’s households are the fortunate recipients of near-record- low mortgage rates. Few periods in history have seen such affordable refinance terms.

Get a rate quote from your lender of choice before rate levels rise. Mortgage rates move daily, and throughout the day. When you find the chance to lower your housing costs forever, “now” is better than “later.” Next week or next month, the opportunity could disappear.

Now that the economy has picked up some, the housing market is recovering a little, and memories of the financial crisis are fading, some lenders are re-introducing a few “creative” financing methods. It's possible to get an interest-only mortgage again, or get a loan with a low, low rate at the beginning.

An interest-only loan is tempting because the borrower only pays the interest each month. This state of affairs can last from five to 10 years. When you only pay the interest, it feels like you can “afford” more house. You aren't paying the principal, so you are only paying one part of the loan, and it seems like a good idea. However, you could actually end up in big trouble.

Building Equity Slowly

One of the biggest problems with an interest-only loan is how it hampers your ability to build equity in your home. An amortization calculator can help you see how fast your mortgage balance is decreasing. With an interest only loan, you're not paying down the principal, so you really aren't making much headway.

If you have to sell your house, you might find that there isn't enough equity in your home to leave anything left over for you after the sale goes through. It also makes it practically impossible to refinance your home, since you don't have the equity needed to put lenders at ease.

A home bought with an interest-only mortgage seems affordable at first, but it quickly becomes apparent that it's not affordable in the long run.

Paying the Cost Later

The biggest problem with getting an interest-only mortgage is that you end up paying a lot more later. Once you start paying on the principal (something that happens after the initial period is over), payments can skyrocket. It's vital that you understand this reality of interest-only home loans.

Many homebuyers who took the plunge with interest-only mortgages prior to the housing crash and financial crisis did so expecting to make more money in a few years. They thought of a higher income, able to handle the payments.

Other homebuyers assumed they would be able to refinance. Even though they weren't paying down principal, the assumption was that housing costs would keep climbing, so equity would be built, even without mortgage principal payments. They could refinance before the higher payments hit, and things would work out.

We all know how that went.

Unfortunately, the fact that these types of loans are starting to become available again means that there could be more problems down the road. And, of course, analysts are on the watch for what is going to happen in the next little while, since there are still interest-only loans from the past that still haven't worked their way through the system.

One of the cool tools offered by CNN Money right now is a calculator that lets you see whether or not your home has been a good investment. You enter information on when you bought your home, as well as how much it cost. Then you enter how much it is worth right now. The results display your total return and your annual return. You can also see how your home's value has fared in comparison to investments like stocks and bonds.

I entered my information in the field, and found that my annual return is 1.0% on my home. This isn't surprising, since the appraisal associated with the refinance I completed indicates that our home has increased in value a little bit since we bought in 2007. CNN Money's calculator indicates that the average U.S. home has seen an annual loss of 4.7% in the same period of time.

But how does my home's value compare with the performances of stocks and bonds since September 2007?

Well, to tell the truth, I wasn't surprised to see that stocks have returned 3.1% annualized since then. With the recent gains in the market completely erasing the disappointing years just following the financial crisis, it's not hard to understand why stocks have seen better returns than residential real estate. Bond have done even better, offering a 5.6% annualized return, according to the CNN Money calculator.

What the Calculator Doesn't Account For

Of course, the calculator is quite simple, and doesn't account for some of the costs associated with home ownership. Your home is one of those assets that has potential, but can really cost you over the long term. That 1.0% annualized return calculated by CNN Money doesn't take into account the amount of interest I've paid on the home in the last 5 1/2 years. Even after I account for the tax deduction associated with the taxes, that 1.0% annualized return is basically erased. And that doesn't include the cost of property taxes (even with offsetting tax deductions), utilities, landscaping, and maintenance.

Once all of those things are added into the equation, I've been losing money on the house.

The calculator also doesn't take into account the reality of trying to sell a home. Even though the appraisal says one thing, I know that we won't get that much back for it. To sell a home in my neighborhood, where there are for-sale signs everywhere and others are lopping $15,000 to $20,000 off their original buying prices to sell quickly, we're going to be stuck paying to discharge our mortgage when all is said and done (assuming we end up moving in the next 12 months).

Of course, the return on investment on a home isn't all financial. Some of it is emotional. My family has enjoyed living in this house. We have been able to landscape it how we want, and we have been able to arrange matters as we prefer. Additionally, there's something nice about a home that we can't be kicked out of when the lease is up (happened to us once when the owner decided she wanted the house for her grandkids). Being able to call someplace “home” and give our son a secure place to return to has its charms.

So, even though the home hasn't been a solid financial investment, it's been worth it to us in other ways.

I was reading my recent issue of Consumer Reports Money Adviser when I came across a small item on deceptive mortgage ads. I've seen a few of these myself recently. You've probably seen them as well. They appear online, on TV, in the newspaper, and even in direct mail to your home. I've lost count of the number of “FHA refinance” letters I've received in the mail in recent weeks.

It's important to be on guard when you see these ads, since they often promise something that is too good to be true. Some of the items you might notice in these ads include:

Really low fixed rates advertised.

Guaranteed approval.

Implication that the advertiser is affiliated in some way with FHA.

While it's true that there are some government programs out there to help you refinance your home, you need to be careful about answering these types of ads.

My Efforts to Refinance

I am going through a refinance under HARP. (Or at least trying to go through one. Income, as always, is a snag because mine and my husband's are both irregular.) I've been thinking about refinancing for a long time, but have hesitated because I'm not sure when we will move. When I talked to my banker, it was a rather discouraging experience, so I put it out of my mind for a while.

I started thinking about it again when the direct mail ads started arriving — at a rate of three or four a week. I didn't seriously think of using any of them, though. A lot of the letters included very vague information and promises of fixed rates below 3%. Additionally, the FHA logo was prominent. Upon flipping over many of the letters, though, and reading the fine print, two things became apparent:

These aren't companies associated with the FHA: Even though the logo is prominent, the fine print on the back says that the company isn't associated with the FHA. However, the companies are using the fact that many who got home loans with the help of the FHA are eligible for government programs.

The rate isn't truly fixed: Again, I had to go to the fine print to see this. But the “fixed” rate was often a portion of a 5/1 ARM. So the rate is only fixed for a limited period of time during the term of the loan.

If you aren't watching carefully for these items, they might slip past you, causing you to feel that you are getting a great deal, and that you are protected because the FHA is involved.

My own refinance is being handled through a reputable, major company that I sort-of approached (with the help of Quizzle). Rather than answering an ad seen randomly on the Internet or sent to me via direct mail, I started the process mostly on my own.

Before you agree to a mortgage, make sure you read through the terms, and you understand the entire loan. And, if you are concerned that you are seeing deceptive mortgage ads, you can get more information from the FTC.

Home prices are still quite low, and mortgage rates remain at record-low levels. As a result, many consumers are considering buying homes right now. It's possible to get a good deal, and it's likely that rates will start rising in a few years. Because of the current conditions, it seems reasonable to buy a home right now. And, even if you don't want to buy another home, it can make sense to refinance, locking in a lower rate for the remainder of your home mortgage loan.

But what if you're self-employed? Will you be able to get a mortgage when you don't have a W-2 and pay stubs you can show your lender? Even with the tighter lending standards, you can be approved for a home mortgage loan, even if you're self-employed and running a home business. Just be prepared to show a lot of documentation.

What Documentation Will You Need?

If you are self-employed, you will have to show your latest tax returns. Normally, the lender averages your last two tax returns to get an idea of your monthly income. This can be somewhat distressing for the self-employed, since many of us take every deduction we can in order to reduce taxable income. However, there are other ways to show that you are making a solid living from your efforts. You will probably be asked for a quarterly profit and loss statement. Indeed, if you want a FHA loan, you will be required to submit a year-to-date profit and loss statement if your last tax return was filed more than a quarter ago.

Another option you have is to pay yourself a salary. If you have organized as an S-Corp., and even if you have another business organization, it's possible to pay yourself a salary. You can show that your business venture is enough to provide you with a regular salary, and that can bolster your case. You might also show your bank account statements as a way to prove that money is coming in. When I applied for a mortgage five years ago, my lender's underwriters required that I hire an accountant to perform an income audit to help establish my income.

Credit, Debt, and Assets

On top of your income, lenders also want to know what your current financial situation looks like. Lending standards have been tight since the global financial crisis, and this is especially true for self-employed borrowers. If you are self-employed, you need to make doubly sure that your situation is solid. You will, of course, be subject to a credit check. Additionally, your lender will want to know your debt to income ratio. If you have a high debt to income ratio, lenders are likely to be concerned that one bad month at your business could lead to problems.

You will also have to show what assets you have at your disposal for a down payment, as well as in reserve. Lenders generally want to see that you have two or three months' of mortgage payments in reserve before they approve you. As long as you have the assets and good credit to back up your income, you should be able to secure a mortgage loan — and get a good interest rate to boot.

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